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New Canadian technical bill affects foreign affiliates.


On December 20, 2002, the Canadian Department of Finance finally released its long-awaited package of technical amendments. The draft legislation is designed to address a number of technical problems with the Income Tax Act that have accumulated during the last several years.

Many of the proposed amendments to the foreign affiliate rules address problems with the legislation that was introduced in 1995, when the rules were last significantly amended. Many of the amendments were expected, and implement changes of a relieving nature that were "promised" to taxpayers or their representatives in a series of so-called comfort letters. Those promises appear to have been kept, with one notable exception. Several changes recommended by groups such as Tax Executives Institute and the Joint Committee on Taxation of the Canadian Bar Association and the Canadian Institute of Chartered Accountants (the Joint Committee) have been included, but others have not.

Not all of the amendments are of a technical nature. In particular, two of the proposed changes relating to the disposition of foreign affiliates and property held by foreign affiliates were not expected, and may have a significant negative effect on transactions occurring after December 20, 2002.

This article focuses on the most significant changes made by the technical bill.

The General Section 95 Election

If a taxpayer wishes to apply a relieving change retroactively to a taxation year commencing after 1994, an election is available to do so (the general section 95 election or "general election"). The general election, however, entails the retroactive application of most of the foreign affiliate amendments contained in the technical bill, many of which deal with completely unrelated issues and are not of a relieving nature. This aspect of the technical bill was expected, and has been subject to much criticism. To date, however, Finance has not been persuaded to abandon this "all or nothing" approach.

The decision whether to make the election will involve a significant amount of analysis. Fortunately, the decision may not be required to be made for some time because of the need for consultation as well as the vagaries of the legislative process. The election is required to be filed by the due date for the taxpayer's return that includes the date when the legislation receives Royal Assent.

The review and processing of returns where the general election is made will also present a significant burden to the Canada Customs and Revenue Agency (CCRA). The legislation provides that the normal reassessment period limitations will not apply to the extent needed to give effect to the general election. The CCRA seems to have an unlimited period of time to review returns for the relevant period and make any adjustments within the scope of the general election, both positive and negative.

Reorganizations and Other Transactions

Two of the proposed amendments to the foreign affiliate rules are unexpected and can have a significant effect on common transactions. Fortunately, neither is part of the general election and, hence do not affect transactions occurring before the December 20, 2002, release date.

The first proposed change relates to certain transfers of shares of a foreign affiliate within a non-arm's-length group. In many cases in which a specific rollover provision (subsection 88(3) or paragraphs 95(2)(c), (d) or (e)) does not apply, the proposal (in proposed subsection 93(1.4) of the Act) would deem the shares transferred to be outside the definition of "excluded property." Consequently, any gain realized by an affiliate on the disposition of the shares (in excess of the amount eligible for a section 93 deemed dividend election) would create FAPI (foreign accrual property income), which is taxed immediately in the hands of the Canadian shareholder if the affiliate is a controlled foreign affiliate. If no consideration is paid for the shares, the vendor would be deemed to have received proceeds equal to the fair market value of the shares pursuant to section 69 of the Act.

The draft regulations also restrict the amount of surplus eligible for the section 93 deemed dividend in these circumstances. Draft regulation 5902(7) will prevent the taxpayer from accessing the surplus balances of affiliates owned by the affiliate that is the subject of the disposition.

According to the explanatory notes, the proposals are intended to prevent taxpayers from utilizing internal reorganizations to create additional surplus or an increase in the tax basis of shares in circumstances in which the shares transferred continue to be part of the group and continue to have surplus balances in respect of the taxpayer or a non-arm's-length party. Unfortunately, the proposals' consequences appear to be more severe than required to achieve those objectives.

There are many circumstances in which it is necessary or advisable to transfer the ownership of foreign affiliates within a related group. Such transactions occur for a variety of reasons unrelated to Canadian taxation. In many instances, shares of an affiliate are transferred without the issuance of shares to the vendor as consideration (a requirement for a paragraph 95(2)(c) rollover) since the receipt of shares may not be necessary for a tax-free transaction in the local jurisdiction. Now, many taxpayers have been forced to put such internal reorganizations on hold pending a determination of the effect of the new rules, and what is hoped will be a reconsideration of the draft legislation by the Department of Finance.

Transactions occurring after December 20, 2002, are grandfathered only from the application of the proposed rules if the disposition was required to be made under an agreement in writing existing at that date.

The second proposed change of significance also applies to dispositions occurring after December 20, 2002, but does not contain any grandfathering relief. The regulations currently contain a rule that prevents the recognition of surplus where capital property used in an active business is transferred to another foreign affiliate, and the transfer is eligible for rollover treatment under the local tax law. The draft legislation would significantly broaden this rule to extend its application to:

* all dispositions (other than certain rollover transactions), including dispositions to arm's length purchasers; and

* all excluded property (including shares of another foreign affiliate), not only capital property used in carrying on an active business.

The proposed rule would not apply if the gain or loss is included in an amount that was taxable under foreign law in computing the affiliate's earnings from an active business carried on by it (paragraph 5907(5.3)(a) of the Regulations).

There are a number of issues associated with the proposed rule, including its application to the sale of an affiliate by a holding company to an unrelated purchaser. Even if the sale of the affiliate is taxable in the holding company's jurisdiction (which is frequently not the case where tax planning has been undertaken) the gain would not be included in the earnings from an active business of the holding company carried on by it (as required by Regulation 5907(5.3)). As a result, no exempt or taxable surplus would be recognized in respect of the disposition. Any proceeds returned by the holding company to the Canadian shareholder in excess of the adjusted cost base of the shares would create a capital gain that could not be reduced to take into account foreign tax paid in respect of the gain.

Informal discussions with Finance officials suggest that this rule is likely to be modified to exempt dispositions of shares of another affiliate provided that the disposition is subject to tax in the holding company's jurisdiction. It is not clear, however, whether an exemption would be available if the holding company's jurisdiction imposes an income tax but provides a participation exemption on the disposition of shares of controlled foreign corporations. Although a gain reduction mechanism similar to our section 93 deemed dividend election would likely be acceptable, a complete exemption may not be. This will obviously be a significant issue in discussions with Finance.

The proposed rule is also problematic in its application to entities such as U.S. limited liability companies (LLCs) that have elected to be treated as disregarded entities for local tax purposes. No surplus may be recognized on the disposition of excluded property in the course of the LLC's business because the owner or owners of the LLC, not the LLC itself, are taxable in respect of the enterprise's earnings. This is of particular concern since the new provision applies to dispositions of all excluded property, such as inventory, and is no longer restricted to capital properties.

Apparently, Finance did intend to extend the application of the rule beyond capital property, despite contrary indications in the draft legislation (such as a reference in subsection 5907(5.3) to "gain or loss," rather than "income, gain, or loss"). It is expected, however, that Finance will clarify that the rule will not apply to dispositions of excluded property, including inventory or capital property, made in the ordinary course of a taxpayer's active business. The disposition of all the assets of a business, however, will likely be considered to be outside the ordinary course of business and, hence, intended to be subject to the rule.

The Department of Finance has requested comments on the proposed legislation, and it is likely that these two proposals will be the subject of a significant amount of discussion. In the meantime, taxpayers should be cautious when considering many common transactions involving their foreign affiliates.

Several other changes are proposed to the reorganization provisions, most of which are of a restrictive nature. These include:

* the potential to create FAPI on certain subsection 88(3) liquidations of a foreign affiliate into its Canadian shareholder;

* the reduction of surplus pools where a section 87 or 88 "bump" is claimed in respect of shares of a foreign affiliate; and

* the requirement to reduce surplus of a parent affiliate on the dissolution of a subsidiary affiliate that has a deficit; The deficit formerly disappeared.

A number of generally relieving changes are also proposed:

* the paragraph 95(2)(d.1) and (e.1) rollovers for certain foreign mergers and liquidations of certain affiliates into other affiliates will be extended to non-capital property;

* paragraph (e.1) will be clarified by deleting the words suggesting that the two affiliates must be resident in the same country; although the CCRA had not interpreted the paragraph as imposing that requirement, the words are ambiguous; and

* the definition of "disposition" will be amended retroactively to provide that the cancellation of shares on a foreign merger for no consideration (and similar transactions) will not be considered to be a disposition of the shares.

A number of problems affecting taxpayers owning foreign affiliates that were identified by the Joint Committee and others were not addressed in the technical bill. These include:

* the loss of a future subsection 91(5) deduction in circumstances where FAPI is earned by a foreign affiliate and the shares of the affiliate are transferred to another affiliate under subsection 85.1(3);

* the broad definition of "specified financial institution," which includes any Canadian corporation related to a foreign affiliate carrying on business as a captive insurance company;

* the apparent lack of tax basis in respect of property transferred to an affiliate for no consideration; and

* the lack of a deduction for hypothetical foreign taxes in computing taxable surplus in paragraph 5907(13)(a) of the Regulations (to provide consistency with paragraph (b) of the provision).

Relief for Tax Rate Reductions

On a positive note, Finance proposes to take into account the recent reduction in Canadian tax rates in determining whether FAPI of affiliates and taxable surplus dividends from affiliates will be subject to tax in Canada. The definition of "relevant tax factor" will be amended to reduce the previous 38-percent tax rate by the general rate reduction for the year as provided in section 123.4.

Currently, FAPI and taxable surplus dividends are taxed in Canada to the extent the foreign tax relating to those amounts is less than 38 percent. For 2002, the target rate will be 35-percent, declining to 33 percent in 2003 and 31 percent in 2004. This change will lessen the concern about potential FAPI and facilitate the repatriation of dividends from certain moderately taxed affiliates.

Financing Foreign Affiliates

A number of significant changes are proposed in the financing area. While most of these changes were anticipated and are relieving in nature, certain problems remain. All of these changes are part of the general election.

(1) One Promise Not Kept

One highly anticipated change was not included in the technical bill. In many cases, Canadian taxpayers borrow in a foreign currency to invest in equity of foreign affiliates. This provides a natural hedge: any gain on the share investment relating to currency fluctuations is offset by a corresponding loss on the repayment of the debt (and vice versa). The taxpayer may not be hedged for Canadian tax purposes, however, if currency fluctuations result in a loss on the share investment. The loss is denied to the extent that the taxpayer has received exempt dividends on the shares; the gain on the debt is taxable.

Finance officials stated in a comfort letter that they would recommend an amendment to eliminate the denial of the loss in these circumstances. While they apparently remain in favor of such an amendment, they are considering how to structure such a rule, particularly where the circumstances are complex.

For example, in most so-called "Tower" structures used to finance U.S. subsidiaries, the third-party debt is held by a partnership of the Canadian taxpayer and a related company. However, the U.S. LLC (which ultimately finances the taxpayer's U.S. operations) is held by another related Canadian company (a Nova Scotia unlimited liability company). Therefore, upon unwinding the Tower structure, any potential loss on the shares of the LLC would be realized by the Nova Scotia ULC, whereas the gain on the debt would be realized by the partnership.

(2) Hedging of Currency Exposure by Foreign Affiliates

The draft legislation finally addresses the treatment of hedging transactions. A series of amendments will treat the hedging transaction similarly to the underlying transaction that is the subject of the hedge, assuming that it can be identified. Previously, income, gains and losses on hedging transactions were generally considered to create FAPI income, gains, and losses.

(3) Loans Made on Capital Account

If a loan is made by a foreign affiliate and the loan is made on capital account, any gain or loss on the repayment or settlement of the loan relating to currency fluctuations between the calculating currency of the affiliate and the currency of the loan will be a gain or loss from excluded property if the interest on the loan is included in active business income under subparagraph 95(2)(a)(ii). The gain or loss will therefore not be included in FAPI but will cause an increase or decrease in surplus of the affiliate. The Joint Committee had suggested that there should be no effect on surplus in such cases (i.e., the gain or loss should be deemed to be nil rather than a gain or loss from the disposition of excluded property--the result which applies if the loan is made in Canadian currency). This suggestion was rejected by the Department of Finance.

New paragraph (c. 1) of the definition of excluded property in subsection 95(1) should ensure that any hedging gain or loss related to such loans will be deemed to give rise to a gain or loss from the disposition of excluded property. This will ensure the treatment of related hedging transactions parallels the underlying item hedged.

If the loan is on capital account but is not excluded property, the gain or loss on the loan is computed in Canadian dollars and may be deemed to be nil under paragraph 95(2)(g). Any related hedging gain or loss was formerly included in calculating FAPI. Proposed paragraph 95(2)(g.3) will now also deem the hedging gain or loss to be nil.

(4) Loans Made on Income Account

If an affiliate can be considered to be in the money-lending business, loans made by the affiliate as part of that business are considered to have been made on income account. Any income or loss on such loans relating to currency fluctuations previously gave rise to FAPI or FAPL, even if the loans themselves were excluded property. This problem arose because the definition of FAPI only excluded capital gains and losses arising from the disposition of excluded property. Income or loss realized on such a loan was included in FAPI as income or loss from an investment business.

Paragraph 95(2)(g) was amended in 2001 for taxation years after 1999 (or after 1994 on an elective basis) to extend its application to transactions on income account. Therefore, the income or loss from such loans, relative to the Canadian dollar, was deemed to be nil, and no FAPI or FAPL would arise. The related hedging income or loss, however, was still included in computing FAPI.

The technical bill revisits the issue, and adopts a different approach. Proposed subparagraph 95(2)(a)(v) and paragraph 95(2)(f.2) will deem the income or loss from the disposition of excluded property that is not capital property to be included in active business income and to be calculated in the affiliate's calculating currency. Therefore, income or loss with respect to such loans will not be included in FAPI but will affect the affiliate's surplus balances (and will not be deemed to be nil under paragraph 95(2)(g)). Related hedges giving rise to income or losses on income account will also generate active business income or losses under new subparagraph 95(2)(a)(vi).

A taxpayer that previously made an election to apply the amendment to paragraph 95(2)(g) on a retroactive basis must now consider whether to make the general election in respect of the technical amendments. If the general election is made, it will effectively reverse the effect of the previous election for the years in question. Under either scenario, no FAPI or FAPL will arise in respect of the loans, but the surplus accounts of the affiliate will be affected. Barring other factors, a taxpayer will be inclined to make the general election if income was realized on hedges made on income account or income was realized on loans made on income account (since the general election would allow for the creation of surplus). The general election will be less attractive if the affiliate had generated significant usable hedging (FAPI) losses.

(5) Taxation of the Borrower

With respect to the taxation of the borrower, a number of relieving and clarifying amendments have also been made. If the borrower realizes a foreign exchange gain or loss on the settlement or extinguishment of the debt, the gain or loss is deemed to be a gain or loss from the disposition of excluded property under paragraph 95(2)(i) if the debt related at all times to the acquisition of excluded property. It was not clear whether this provision applied if the borrower used the funds to pay business expenses, such as wages or rent. The provision is amended to apply where all or substantially all of the borrowed funds were used to acquire excluded property, to earn income from an active business or a combination of those uses.

Any hedging gain or loss with respect to such a borrowing is also now deemed to be a gain or loss from the disposition of excluded property.

Paragraph 95(2)(i) does not appear to extend to funds borrowed to repay debt that was borrowed for a permissible purpose. Finance is aware of that issue and will hopefully correct that in the final legislation.

(6) Making the General Election

The general election must be made in respect of all affiliates of the taxpayer and in respect of all relevant years beginning after 1994. A taxpayer is not able to make the election on a selective basis and eliminate FAPI arising in some affiliates, while leaving FAPI losses unaffected in other affiliates. The "all or nothing" approach makes sense in the context of the financing amendments, which are related. It makes less sense in the context of other amendments contained in the bill that Finance has chosen to include in the ambit of the general election.

The Deeming Rule: Amendments to Paragraph 95(2)(a)

A number of amendments are proposed to paragraph 95(2)(a) ("the deeming rule"), which deems income that would otherwise be income from property or an investment business to be income from an active business. Most of the amendments are intended to be relieving but can be applied retroactively only as part of the general election.

(1) Loans to Partnerships

Clauses 95(2)(a)(ii)(A) to (C) apply in respect of amounts received by a foreign affiliate from certain partnerships. The deeming rule does not apply if the related non-resident or foreign affiliate that is a member of the partnership is a "specified member" of the partnership. The definition of specified member includes all limited partners and partners not actively engaged in the business or a similar business.

The concept of specified member will be replaced with the concept of qualifying member, as defined in new paragraph 95(2)(o). Limited partners will no longer be disqualified, and can meet the test if they are actively engaged in the business or a similar business or own at least a 10percent interest in the partnership (determined on the basis of fair market value). At least I percent must be owned directly, with the remainder of the 10 percent permitted to be owned by related parties.

Finance did not adopt the Joint Committee recommendation to address the application of the deeming rule in circumstances where an affiliate borrows funds to purchase an interest in a partnership. The CCRA has previously stated, however, that the deeming rule should apply if the partnership earns active business income and the affiliate deducts the interest on the borrowing in computing its earnings from that active business.

(2) Loans to Holding Companies

It may be that none of the foreign affiliate provisions is more problematic than the "holding company rule" in clause 95(2)(a)(ii)(D) of the Act. The rule is generally intended to allow the deeming rule to apply in respect of a loan to a holding company where the holding company uses the funds to buy shares of another affiliate resident in the same country if the shares are excluded property and the interest income is relevant in computing the income of a group of corporations resident in that country, typically under a consolidated filing or group relief system. The technical bill attempts to address two of the many problems with the rule, with less than complete success.

The first change relates to the "subject to taxation" requirement. The rule requires the holding company and the affiliate acquired (the "second" and "third" affiliates) to be resident in the same country and subject to taxation in that country. This requirement cannot be met by affiliates such as U.S. LLCs that are not subject to tax on their earnings. New subclause 95(2)(a)(ii)(D)(V) provides that the affiliates must be subject to tax in that country or the shareholders of the affiliate must be subject to tax on all or substantially all of the income of the affiliate (or would be if it had income in the relevant year).

The second change relates to the requirement that the shares of all the affiliates in the group meet the definition of excluded property (i.e., that all or substantially all of their property is used in an active business), not just the third affiliate. This requirement cannot be met if any affiliate in the group is dormant or earns FAPI or FAPL. The technical bill proposes to eliminate the excluded property requirement for these affiliates but replaces it with an income-based test.

New subclause (VI) provides that the interest paid or payable by the second affiliate must be relevant in computing the income of:

* a group of affiliates where all or substantially all of the amount that is the total of all amounts each of which is the income or absolute value of the loss of a group affiliate from a source is attributable to incomes and losses from an active business; or

* the second affiliate, if the third affiliate's income is taxed in the hands of its shareholders and all or substantially all of the total of all amounts each of which is the income or loss of the third affiliate from a source is attributable to incomes and losses from an active business.

Although the new test solves the problem it was designed to address, it will create anomalous results. For example, if the group is composed of one affiliate with a billion dollars in active business assets that earns $8 million in a particular year, and two other affiliates, one which earns $1 million of FAPI and one which has a $1 million FAPI loss, the test will not be met. The total absolute value of the "bad" income or loss of $2 million out of a total income or loss of $10 million will exceed the threshold for the "all or substantially all" test (on the assumption that CCRA is correct and those words translate to a 90-percent threshold). In the next year, the active business affiliate may have income of $50 million or a loss of $50 million. In that year, if the other affiliates report results similar to the prior year, the test would be met.

There are many other issues raised by the proposed test, including:

* the additional unpredictability of the application of the test in some countries, such as the U.K., where an affiliate may be part of the group one year, and not part of the group the next year, depending on whether or not it is using a loss of another affiliate that year;

* the lack of clarity regarding how "income" or "loss" should be measured for this purpose;

* the apparent inclusion in the "bad" total of losses created by borrowing to buy shares of another affiliate, including the holding company itself; and

* the apparent inclusion in the "bad" total of dividends received by one affiliate from another affiliate, even though they may be paid out of active business earnings.

The uncertainty surrounding the proposed test merely adds to the uncertainty already inherent in the requirement that the interest paid or payable by the second affiliate be "relevant" in computing the earnings of a group of affiliates. It is clear from a review of the CCRA interpretation letters on this subject that this test is not an easy one to meet given the requirements of the various tax systems to which the rule must apply.

These changes to the holding company rule are part of the general election package. Where a taxpayer has been relying on this rule in past years, a very hard look will have to be taken to determine whether or not the election has negative implications in any particular year.

Finance officials are aware that there are significant problems with the proposed changes, and appear to be open to alternatives. From a policy perspective, it is unclear why the rule needs to be so tightly restricted. The basic rule requires the holding company to use the funds to purchase shares of another affiliate that meet the excluded property test. If another affiliate within the group earns FAPI, the interest expense of the holding company may reduce the local tax liability associated with that FAPI where consolidated filing or group relief is available, but does not reduce the Canadian tax liability associated with that FAPI. It is unclear why the existence of the other affiliate should cause the interest paid or payable by the holding company to be FAPI to the recipient.

(3) Sale of Property Used to Earn Deemed Active Income

As noted in the context of loans made on income account, the disposition of excluded property that is not capital property was formerly included in computing FAPI. This was a particular problem for an affiliate that owned intellectual property or other eligible capital property and licensed that property to other affiliates. The royalty income of the affiliate was included in active business income by the application of the deeming rule, but a gain on the disposition of the intellectual property would be included in FAPI.

New subparagraph 95(2)(a)(v) will include the income or loss in active business earnings of the affiliate. New paragraph (a.1) of the definition of exempt earnings and exempt loss will capture the non-taxable portion of the gain or loss.

This is a significant amendment for many taxpayers. As with many of the amendments, it applies to taxation years beginning after December 20, 2002, unless the general election is made.

A similar clarifying change is proposed to the definition of "excluded property." To paraphrase, it currently provides that a property will be excluded property if it is (a) used or held ... for the purpose of (earning) income from an active business or ... (c) an amount receivable, the interest on which is income from an active business under the deeming rule.

The inclusion of paragraph (c) raised the issue whether other capital properties used to earn income benefiting from the deeming rule (such as licensed technology or rented buildings) met the definition of excluded property. The CCRA consistently interpreted such property as meeting the definition by reason of paragraph (a). The definition is proposed to be amended to restrict paragraph (a) to property used in a business carried on by the affiliate directly, and to expand paragraph (c) to explicitly capture all property used to earn income deemed active under paragraph 95(2)(a). Although the change is part of the general election, it is doubtful that the election is required in respect of this issue for prior years.

(4) Qualifying Interest Test

The deeming rule requires the taxpayer to have a qualifying interest in the recipient affiliate (generally shares representing 10 percent of the votes and value) and, in certain cases, a qualifying interest in a payor affiliate. These requirements may not be met if the affiliates are held by different Canadian related companies and there is no cross-ownership.

As promised in a comfort letter, Finance has introduced new paragraph 95(2)(n), which will deem a taxpayer to have a qualifying interest in a foreign affiliate (even if it owns no shares of the non-resident corporation), if the non-resident corporation is a foreign affiliate of a related Canadian corporation in which the related corporation has a qualifying interest. The amendment is part of the general election.

Business Income Included in FAPI

A number of provisions deem income that would otherwise be income from an active business to be income from property or income from a business other than an active business. When one of these rules applies, the income is included in FAPI.

(1) Investment Business

The income from an "investment business" or business of earning income from property such as interest, rent, royalties, etc., is included in FAPI unless the exceptions contained in the definition can be met. These exceptions will be relaxed.

The first exception relates to certain regulated businesses, such as banks, trust companies, insurance companies, etc. The business must be regulated under certain laws under which the affiliate is governed. The amendment is intended to provide for more flexibility in this respect, though the drafting is particularly difficult to decipher.

The second exception relates to businesses that employ more than 5 employees full-time in the active conduct of the business. This exception is amended in two respects.

First, the exception will now apply to income earned by a partnership even if the affiliate that is a member of the partnership is a limited partner. As with the changes to the deeming rule, the specified member test will be replaced by a qualifying member test, which requires the partner to either be actively engaged in the partnership business or a similar business, or to meet the 1-percent/ 10-percent interest in the partnership test.

Second, the exception will be broadened to allow the greater than 5 employee test to be met by contracting for the services of a broader array of individuals, including employees of a qualifying member of a partnership and employees of a qualifying shareholder of an affiliate. The new definition of qualifying shareholder is in paragraph 95(2)(p), and requires the shareholder to own shares representing at least 1 percent of the votes and value of all shares of the affiliate, and the shareholder and related persons to own shares representing at least 10 percent of the votes and value of all shares of the affiliate.

The changes are welcome, but do not address many of the problems associated with the greater than 5-employee test. There remain many circumstances in which operations are carried on in separate affiliates for business reasons, such as limited liability, and the ability to contract for the services of employees of other entities can provide no relief. The rule in subparagraph 95(2)(a)(i), which may deem income of an affiliate to be active business income if it is directly related to the active business activities of another affiliate, is not helpful unless there is at least one affiliate that exists which employs more than 5 employees full-time in the active conduct of its business. The Department of Finance has maintained its position that it will not agree to introduce a test that simply adds up the number of employees employed by related entities carrying on similar businesses.

(2) Purchasing and Selling Activities

In some circumstances, paragraph 95(2)(a.1) deems an affiliate's income from the sale of property to be included in FAPI. Such affiliates typically purchase or sell goods for the Canadian parent company or related parties. There is an exception to the rule for Canadian-produced goods and for goods produced in the country where the affiliate is resident.

The technical bill proposals revamp the rule, and introduce a new exception for unrelated party transactions. While the drafting remains torturous, the changes appear to be of a relieving nature, and accommodate a greater variety of business activities, including the production of goods by an unrelated contract manufacturer, wherever resident.

(3) Services Provided by Affiliates

Certain income from services earned by a controlled foreign affiliate is included in FAPI. The rule generally applies if the fee for the service is deductible in computing income by a Canadian related person.

The technical bill proposes to extend the application of paragraph 95(2)(b) to fees deductible by another controlled foreign affiliate in computing FAPI. Therefore, services provided to another affiliate's investment business, for example, would create FAPI. This change would apply prospectively.

Two other proposed changes are relieving, and ensure that the business of transmitting electronic signals or electricity will not be caught by the rule. Nor will contract manufacturing or processing goods to the taxpayer's specifications. Those proposals are part of the general election.

(4) Fresh Start Rules

When the rules were amended in 1995, many businesses that had been considered to be active businesses were reclassified as investment businesses or as businesses giving rise to income from a business other than an active business. The fresh start rules were intended to provide for a deemed disposition of property of the business and a deemed reacquisition of that property. Unfortunately, the rules were flawed in many respects.

The technical bill contains a series of amendments designed to address these flaws. Taxpayers have the option to apply these amendments on a retroactive basis by making a "Fresh Start Section 95 Election." This election is similar to but separate from the general election.

The fresh start rules are also proposed to be extended to apply in circumstances where a business was a "FAPI business" in a particular year and becomes an active business in a subsequent year. For example, a business may cease to be an investment business if a sixth employee is hired. There will now be a deemed disposition of property of the business, resulting in the inclusion in FAPI of all accrued income and gains.

Year of Acquisition of a Foreign Affiliate

The draft legislation contains a number of provisions intended to apply to the taxation year in which a nonresident corporation becomes a foreign affiliate of a taxpayer. The general rule is that the taxpayer must report any FAPI earned by the affiliate from the beginning of the affiliate's taxation year in which the affiliate is acquired, regardless of what date in the year the affiliate is acquired.

New paragraph 95(2)(f. 1) provides that FAPI will not include any income or loss realized or accrued during the period the foreign affiliate was not a foreign affiliate of the taxpayer or certain other persons. The rule also provides that FAPI is to be computed in accordance with Part I of the Act and in Canadian currency, although that statement is likely made only for greater certainty, since that was generally believed to be required.

Similarly, new subsection 95(2.21) is designed to prevent the inclusion in active business income under the deeming rule in paragraph 95(2)(a) any income arising in respect of a transaction or event occurring before that time.

Finally, paragraph 95(2)(f) currently excludes from FAPI any capital gain or loss that accrued before the affiliate was a foreign affiliate, but only applies to the extent that the property disposed of was owned by the affiliate at the time the affiliate was acquired. If an affiliate disposes of a capital property during the year but before the taxpayer acquires the affiliate, the gain will be included in FAPI.

Finance has addressed this problem by deeming the affiliate to be an affiliate for the entire year for purposes of determining what property was owned by the affiliate (subsection 95(2.22)) but not for the purpose of determining the portion of the gain that accrued while the affiliate was a foreign affiliate (subsection 95(2.23)).

The provisions appear to work correctly if an affiliate sells a property mid-year that it owned at the beginning of the year, but do not appear to accommodate property that was acquired after the beginning of the year and before the affiliate was acquired. For example, assume an affiliate with a calendar year taxation year buys a property in January, sells it in November for a gain, and is purchased by the taxpayer in December. That gain would be included in FAPI in respect of the taxpayer. If the property is not sold until several years later, the portion of the gain that accrued between January and November would also be included in FAPI.

Section 17: The Parallel FAPI System

The extension of section 17 in recent years has required taxpayers to carefully consider the application of section 17 to many transactions involving foreign affiliates. The draft legislation contains only one change to section 17, to provide that section 17 will not apply if a taxpayer makes an interest-free or low-interest loan to an affiliate and the affiliate uses the funds to repay a debt that is itself exempt from the application of the provision (on the basis that the borrowed funds were used to earn active business income or make certain inter-affiliate loans).

There are many problems with section 17 that Finance has not chosen to address, including the application of section 17 in circumstances where the affiliate borrows to pay a dividend or return capital. It is unclear why these changes, many of which were recommended by the Joint Committee and others, have not been made.


While many of the technical bill changes are welcome, the bill contains some surprises and several provisions that need to be reexamined. No deadline has been provided for making submissions to Finance. Taxpayers should consider the effect of the changes, particularly the reorganization proposals and provisions included in the general election, and make representations as soon as possible.

SANDRA SLAATS is a partner in the Toronto office of Deloitte & Touche LLP, focusing on the development and implementation of international tax strategies. She is a lecturer on the taxation of foreign affiliates at the CICA Part III tax course. She received her Bachelor of Laws from the University of Toronto and a Master of Laws (Taxation) from Osgoode Hall Law School. From 1987 to 1990, Ms. Slaats was employed as a Tax Policy Officer with the Canadian Department of Finance.
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Author:Slaats, Sandra
Publication:Tax Executive
Date:Jan 1, 2003
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